For the past decade, investors have enjoyed a long climb up the “wall of worry.” Perhaps enjoyed is the wrong word: Investors have weathered European debt crises, a peek over a “fiscal cliff” in the U.S., an oil-market collapse, and an undeniable escalation in geopolitical and trade tensions around the world. But through it all, U.S. stocks and bonds have steadily climbed, and any interim market corrections have been short-lived.
During this period, those who owned public equities and fixed income as the core of their portfolios were generally rewarded. This was especially true for managers skilled in finding undervalued or overvalued securities, who used that skill to generate “alpha”—the technical term used to describe incremental risk-adjusted return above or below a market index.
Traditional benchmark-oriented strategies can generate alpha, but generally their results will roughly correlate with those of the benchmark they seek to outperform. This fact is on the minds of a growing number of investors today who are concerned about the market’s direction. They are looking at very low interest rates in fixed income, and a stock market that may be at a high-water mark, and they are asking where else they can turn.
We believe that public equities and fixed income should always be the bedrock of most long-term investment plans, but there are other ways to earn alpha that are largely independent from the market’s movements. We might call these “process-driven” strategies as opposed to “market-driven” strategies. Such strategies may invest ahead of mergers or other corporate transactions, or capitalize on deep knowledge of the intricacies of a company’s capital structure, or seek to directly drive a company’s decisions as an activist investor.
These alternative sources of alpha can potentially offer outperformance if the market’s tide begins to go out. Moreover, the market in recent years has begun to differentiate more between individual securities (as opposed to the post-crisis years when markets were largely driven en masse by swings in sentiment). In such an environment, the active management styles we discuss in this article may have the potential to perform especially well.
TAKING STOCK
With a bull market that has lasted for more than ten years, it is not surprising that so many investors are worried about the end of the road. We want to emphasize that we do not spend our time and resources trying to predict the short-term direction of the market. We simply don’t know what might happen three months or six months from now. But we can look at long-term trends, and gauge how market conditions today look relative to long-term averages.
We know that equity valuations in the U.S. are notably above their long-term trend, according to a fairly wide range of metrics (see chart below). On traditional measures such as price/earnings or price/book value, the S&P 500 Index is trading between 15% and 20% above long-term averages; and on other measures such as Shiller P/E or “CAPE” (a modified P/E ratio that looks at longer-term earnings trends and takes inflation into account), the current premium is much more pronounced.
CURRENT VALUATION PREMIUMS, S&P 500 INDEX
| Metric | Most Recent | Long-Term Average | Premium vs. Average | Timeframe |
|---|---|---|---|---|
| Trailing P/E | 19.4 | 16.6 | +17% | 3/31/1954- 9/30/2019 |
| Price/Book Value | 3.4 | 2.9 | +17% | 3/31/1990- 9/30/2019 |
| EV/EBITDA | 13.3 | 10.6 | +29% | 12/31/1990- 9/30/2019 |
| Shiller P/E | 29.0 | 17.0 | +71% | 12/31/1880- 8/31/2019 |
| Market Cap/U.S. GDP | 1.49 | 0.89 | +68% | 12/31/1974- 6/30/2019 |
Source: Bloomberg. Please see the end of the article for a complete list of terms and definitions. One cannot invest directly in an index.
Further, U.S. unemployment is as low as it has been since 1969; because of this and other economic indicators, the Fed is increasingly concerned about slowing economic growth, and it has reversed course from raising interest rates in 2017 and 2018 to cutting them in 2019. This situation poses challenges for fixed income investors. Compared with past pre-recession periods, there is less room for rates to fall today given their already-low levels (that is, if you believe that the Fed will not decrease rates into negative territory). Because longer-duration positions offer low yields currently, they are typically not very sensitive to falling rates and thus their value as a hedge in balanced portfolios may be limited when compared with past recessionary periods.
On a more positive note, correlations between individual stocks have fallen in recent years. In the years after the 2008-09 financial crisis, securities tended to trade in lockstep with each other as the market focused most of its attention on the big-picture health of the economy. But those correlations have fallen to pre-crisis levels (see chart above), which is an indication that the market is discriminating more effectively between the market’s wheat and chaff. In our view, fund managers should have greater potential to add value through individual security selection given these lower correlation levels.
RETURN TO NORMAL?
In the years following the global credit crisis, intra-stock correlations remained quite high as equity prices were heavily influenced by macroeconomic sentiment. More recently, correlations have fallen back to pre-crisis levels, providing more room for stock pickers to add value with their selections. Active manager returns have generally improved against this backdrop.
CBOE S&P 500 Implied Correlation Index, 1/1/2007-8/30/2019
Source: Chicago Board Options Exchange (CBOE). Please refer to the end of the article for a complete list of terms and definitions. One cannot invest directly in an index.
None of this information tells us where the market will turn over the next few quarters, but all of it suggests that it may be prudent to seek out some diversifying sources of return that don’t depend on a bull market. In the current environment of elevated valuations and low interest rates, it may make sense to consider investment opportunities with low correlation to equities and fixed income. It also may be a good environment for skilled long/short stock pickers, who have the potential for success as long as individual stocks offer differentiated returns from each other. Lastly, as capital has flowed out of active management (including outflows from many of the strategies we outline below), competition has decreased and the potential for outperformance may have improved.
Any number of factors could cause valuations to quickly readjust or correlations to spike. Our goal is always to avoid “betting” on specific market outcomes; instead, we want to position our clients for success in a wide variety of outcomes. For that reason, we believe that the investment strategies discussed below can serve as effective complements to one’s core allocations to equities or fixed income.
FIVE SOURCES OF NONTRADITIONAL ALPHA
Note that the strategies outlined in the table below are generally only available to accredited investors or qualified purchasers who are able to invest in alternative investments.
| Strategy | How It Can Drive Alpha | Why Results May Be Noncorrelated | Notes |
|---|---|---|---|
| Activist | Takes sizable stakes in companies in order to drive strategic changes that can benefit investors | Activists can help create value for shareholders by driving improvements in improved management, capital allocation and long-term strategy. | There are a number of established activist investors with the track record, strong results and reputation that lead companies to engage with them and listen to their suggestions. We have a strong preference for ‘constructive’ activist strategies that focus on long-term results, as opposed to those seeking short-term changes to provide a temporary boost to stock prices. |
| Distressed Credit | Uses a combination of research and activism in an effort to find value in bonds that are threatened by default | Performance depends on the result of complex bankruptcy or liquidation processes that have less to do with general market moves. | Corporate default rates are near record lows, but the amount of “junk bonds” outstanding has doubled over the past 10 years, setting the stage for a potentially fruitful opportunity set if the economy weakens. (Source: Standard & Poor’s) |
| Event-Driven | Seeks out specific “catalyst” opportunities, such as investing ahead of potential M&A transactions or litigation/legislation | Performance is reliant on the execution of a transaction and the analysis of the probability of success. | With record amounts of capital at private equity firms and cash on corporate balance sheets, the number of global M&A transactions recently hit an all-time high, providing a robust opportunity set. (Source: IMAA Institute) |
| Global Macro | Uses macroeconomic expertise in an effort to capitalize on currency, interest rate or index movements or dislocations | Managers are focused on the movements of interest rates, currencies and relative value opportunities in those markets; these factors generally have low correlation with equity markets. | Capital dedicated to these strategies has fallen meaningfully in recent years. As banks have exited proprietary trading activities, competition has fallen even further, which in our view creates a more attractive competitive environment. |
| Relative Value-Credit | Focuses on potential dislocations in value across diverse fixed income markets, or across the capital structure of a specific issuer. | The combination of long and short positions, at times within a single company’s capital structure, can lead to lower market correlation. | Declines in capital dedicated to these strategies from managers and banks has led to decreased competition. While the number of public company stocks has decreased consistently over time, the number of issuers of corporate debt is up nearly 50% over the past 10 years. (Source: Standard & Poor’s) |
As we noted earlier, we think about these strategies as “process-driven” vs. “market-driven.” “Process” is a fairly flexible term in this case—we are referring to a distinct capability or expertise that a manager can use to help drive investment success that has little or nothing to do with the market’s returns. For example, activist investors can drive returns by thinking like a corporate executive or consultant—they invest heavily in a company, gain an influential voice, and seek to guide the company’s actions to a more profitable path. Event-driven strategies can earn alpha from predicting the occurrence of mergers or other corporate transactions, as well as predicting (or even driving) the path of litigation or legislation, and by understanding the likely consequences of those events if they come to pass. Distressed debt strategies often hinge on a manager’s understanding of complex bankruptcy processes and of how the court may apply those processes based on the documented facts of a given situation, and the manager’s ability to negotiate for an attractive share of a company’s value in a restructuring. Relative value (RV) credit strategies succeed or fail based on the manager’s ability to look at a complex corporate capital structure with hundreds or even thousands of different credit issues, and to find inefficiencies in that structure to identify the specific instruments that offer the best combination of risk and reward. RV managers need to be restructuring process experts, with the ability to understand bond indentures, creditor rights and other specialized topics.
In most cases, these investment styles are not heavily impacted by market risk, but each of them carries risks of their own. The fact that a strategy has low correlation with stocks or bonds does not make it inherently safer on an absolute basis. It is essential that investors understand those risks before allocating capital to these strategies.
However, these strategies carry different risks than those faced by traditional equity or fixed income investments. As such, it is likely that their return patterns will also be different than that of the stock or bond markets. By selectively adding exposure to these alternative sources of alpha, we believe that clients can improve their overall long-term results across a variety of positive and negative market scenarios. 
The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.
The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.
The S&P 500® Index represents the large-cap segment of the U.S. equity markets and consists of approximately 500 leading companies in leading industries of the U.S. economy. Criteria evaluated include: market capitalization, financial viability, liquidity, public float, sector representation, and corporate structure. An index constituent must also be considered a U.S. company. The CBOE S&P 500® Implied Correlation Index measures expected average correlation of the stocks in the S&P 500 Index, using SPX option implied volatilities and a weighted portfolio of the implied volatilities of options on stocks in an SPX “tracking basket,” a subset of the S&P 500 comprised of the 50 largest components as measured by market capitalization. Higher values for this index translate to greater correlation of publicly-traded U.S. stocks. Standard & Poor’s, S&P, and S&P 500 are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”), a subsidiary of S&P Global Inc. The S&P 500 Shiller CAPE Ratio, also known as the Cyclically Adjusted Price-Earnings ratio, is defined as the ratio of the S&P 500 Index’s current price divided by the 10-year moving average of inflation-adjusted earnings. Price/Earnings (P/E) refers to the current share price divided by annual earnings per share (based on a trailing period or projections for a future period). Price/Book Value refers to the current share price divided by the company’s book value, or carrying value on the balance sheet, per share (based on a trailing period or projections for a future period). EV/EBITDA is the enterprise value (EV) divided by EBITDA (earnings before interest, taxes, depreciation and amortization). Earnings Growth refers to the growth rate of a company’s net profit. Market capitalization is the market value of the outstanding shares of a publicly traded company or group of companies..
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